Regulation, Market Structure and Role of the Credit Rating Agencies

August 13, 2012

Starting in late summer 2007, credit rating agencies (CRAs) began extensive downgrading of mortgage-backed assets that marked the beginning of a painful financial crisis. The credit rating agencies' downgrading of assets did not cause the subsequent recession, but they did shock the world in how they revealed what were apparently inflated ratings for corporate debt, say Emily McClintock Ekins, a research fellow, and Mark A. Calabria, director of financial regulation studies, at the Cato Institute.

Miscalculations by issuers, investors, credit rating agencies and regulators contributed to the crisis, but such miscalculations should have come as no surprise given the incentive structure of our financial markets.

McClintock Ekins and Calabria say the federal government's role in creating de facto supreme credit rating agencies undermined their incentives to behave and operate properly.

The Securities and Exchange Commission's (SEC) designation of Nationally Recognized Statistical Rating Organizations (NRSROs) inadvertently created a de facto oligopoly of "legitimate" CRAs.

This led to the sector dominance of only three firms: Moody's, Standard & Poor's and Fitch.

Although CRAs were indirectly constrained by their reputation among investors, the lack of competition allowed for greater market complacency.

Government regulatory use of credit ratings inflated market demand for NRSRO ratings, despite the decreasing informational value of credit ratings.

While the NRSRO designation was created in order to protect consumers from poor ratings systems, it has done more harm than good through its contributions to the financial crisis.

Regulations for the financial industry were put into place that conferred inherent advantages on assets with high ratings from the NRSROs.

Regulations incentivize investors to purchase financial instruments with high NRSRO credit ratings, rather than credit ratings with high informational value.

Since it is hard to determine the accuracy of credit ratings, it is understandable why regulators use high NRSRO credit ratings as a proxy.

This system of regulations protected NRSROs from outside competition while creating a lack of innovation or foresight inside the industry.

By removing government-given advantages for NRSROs and allowing free competition among CRAs, more information can be brought to light and more informed financial decisions can be made.